Review: Good Economics for Hard Times

Review: Good Economics for Hard Times

Good Economics for Hard Times: Better Answers to Our Biggest Problems by Abhijit V. Banerjee

My rating: 4 of 5 stars

Economics is too important to be left to economists.

After listening to a series of lectures on introductory economics, I was struck by the degree to which the basic logic of supply and demand was used to make sweeping pronouncements about human behavior and economic policy. The lecturer, starting from the premise that supply and demand is inexorable, would rule out certain policies as working against the market, while promoting those he considered ‘market-friendly.’ But rarely did he stop to actually examine a case study to see how these theories played out, leaving me with the impression of a wholly a priori logic.

The central thrust of this book is that a priori logic cannot be trusted. The economy is complex and unpredictable, so the best way to understand it is through historical case studies and randomized control trials. The authors find that, when we examine the economy in such a way, many of our intuitions about how the it works or will respond to certain policies are wrong. Indeed, though this could hardly be called a revolutionary book—its tone is engaging but mostly academic—the two authors, Banerjee and Duflo, reach quite heterodox conclusions.

One basic economic argument used against permissive immigration policies is that the increased supply of cheap labor will inevitably drive down wages, thus hurting native workers. The logic is simple but it does not hold up under the evidence. In case study after case study, immigration is shown to be either economically neutral or beneficial to native workers. Indeed, ironically—and contrary to what Trump and his ilk may say—low-skill immigrants are better for native workers than highly skilled ones, because they often take jobs that native workers do not want—jobs requiring little communication and much labor. Native workers may even benefit by being promoted to managerial roles. A multilingual immigrant doctor actually competes more directly with native workers than a monolingual immigrant fruit picker.

Perhaps you can see that the above supply and demand argument against immigration is simplistic, since immigrants, apart from increasing the labor supply, also increase demand for goods. Indeed, most professional economists are decidedly in favor of migration. Workers have much to gain from moving to where their skills will be most highly rewarded; and businesses would gain from having good workers. But here the economists’ logic is shown to have its own flaw. Real workers are actually quite averse to migration. Banerjee and Duflo show that, even when a better job may just require move from the country to the city, most will simply not go. There is a large amount of inertia built into real people’s lives—the pull of family, friends, and familiarity—which works against even obviously beneficial moves.

This is not the only way that the real economy is (in economic parlance) ‘sticky.’ Though economists imagine a world of workers ready to move and re-train, of companies willing to fire and hire, banks that drop bad investments and jump on promising new ones, firms willing to relocate to new countries with cheaper labor, new businesses popping up and inefficient ones disappearing—in a word, a dynamic world governed by shifting supply and demand—the real world is consistently stickier than this logic suggests. This seems particularly true in the developing world—the authors’ main area of study—where they found that efficient and inefficient businesses coexisted, where bad-selling product lines were retained, where banks merely rubber stamped loan applications from existing clients, and where people do not migrate for work, or even take the work that is available locally.

Inhabitants of planet earth will likely not be surprised by all this. But the upshot, the authors argue, is that free trade does not deliver all that it promises. Now, the logic of free trade is simple and compelling, grounded in the law of Comparative Advantage put forward by David Ricardo. Simply put, this law states that we all will benefit from trade, since we can all specialize in what we are comparatively better at doing.

But the logic has not exactly played out as hoped. Though touted as a way of propelling developing nations out of poverty, in practice free trade policies have a mixed record. The authors use the example of India, which transitioned from a highly-regulated economy with high tariffs to a free market with low tariffs in the 1990s. The result of this transition was hardly the economic wonder that some economists could have predicted. In many places, wages actually went down rather than up, and in subsequent years much of the economic growth has simply gone to the country’s rich. This is not to say that the results of economic liberalization were all bad, only that it was hardly the panacea that free-market advocates promised.

The consequences for rich nations, like the United States, have also been mixed. While most economic transitions involve winners and losers, the shock of free trade has benefited those who were already ‘winning,’ and hurt those who were already ‘losing.’ In other words, while the big cities full of college-educated workers have grown richer, the arrival of cheap goods—mostly from China—has ravaged many blue-collar communities.

Admittedly, the theory of Comparative Advantage does predict that free trade will temporarily hurt some workers who are forced to compete with cheaper goods from abroad. But the belief in economic adaptability (not to mention the political will to help assuage the problem) was overly optimistic.

Even when jobs disappear, workers do not move. Many simply go on disability and leave the workforce entirely. In short, workers are sticky. Not only that, but the United States has been very bad at redistributing the gains of free trade in the form of worker retraining and extended unemployment. No wonder that many in the country are skeptical of the benefits. However, the authors are careful to note that the solution to this problem is not to impose new tariffs on China. This will only create further economic harm in other sectors (like agriculture) without remedying the harm already done. What is needed, the authors argue, are generous government programs to either re-train displaced workers, or to subsidize industries that are being driven out of business.

This leads us to the longest and most theoretical chapter in this book, that on growth. The argument is fairly dry but the conclusion the authors reach is striking: we do not know what makes economies grow. The greatest years of economic growth were between the end of WWII and the 1970s. This was also a time dominated by Keynesian economics, which led many to give Keynes the credit for this economic miracle. But the magic wore off with the coming of stagflation, which the Keynesian seemed powerless to stave off. This crisis brought the managed economy into discredit, and ushered in the neoliberal revolution, where deregulation, lower taxation, and free trade were seen as the best tools to rejuvenate the economy. Unfortunately, that did not work, either, and growth has never picked up to pre 1970s levels.

Instead, what has grown since the neoliberal turn has been inequality. Rather than stimulate the economy into mad activity, these policies have merely directed what modest economic growth there has been to the much-maligned top 1%. And their political influence has grown right along with their fortunes, which only reinforces the government’s tendency to embrace these sorts of ‘business-friendly’ policies.

As usual, the economic logic used to argue in favor of these policies—that lower taxes on the rich will spur greater activity—is supported by a priori logic rather than actual evidence. But the evidence does not bear it out. People work just as hard whether they are being taxed at 30% or 70%, or not at all, as demonstrated by a series of tax holidays in Switzerland. The notion that high salaries reflect employee value (which supply and demand would predict) is also not supported, as demonstrated by the remarkably high wages paid to those who manage stock portfolios, which consistently underperform against index funds—meaning that the wages are essentially a rent for holding onto money. (And since the high salaries in finance influence salary negotiations in other industries, this increases salaries across the board.)

A strange picture emerges from all this, a picture of an economic policy—at least in the United States—that is entirely divorced from reality. We wring our hands about immigration at a time when immigration is not going up, and even though immigrants pose no credible economic or cultural threat. We argue about tariffs but not about how to actually help those hurt by free trade policies. We cut taxes and deregulate businesses in the name of growth that never appears. Meanwhile, automation is likely to make many of these problems that much worse, and we persist in putting off any action related to the looming climate crisis.

The current pandemic—and concomitant economic crisis—has only put this magical thinking into high relief. Perhaps the best thing to call it is free-market fundamentalism: the belief that the economy, acting on its own, will sort out all of our problems—from poverty to pandemic—without any government aid. Strangely, it is a faith held most ardently by those who see the least evidence for it: people who have been hit by the economic dislocation of free trade. Indeed, at just the time when inequality is rising, we have embraced a kind of social Darwinism that treats the economic pecking order as a perfect reflection of personal merit. This mentality, resting upon the assumption of an imagined economic mobility (which is even lower in the US than in the European Union), justifies both extreme poverty and extreme wealth, since both are ‘deserved.’ To the extent that anyone is held responsible for the situations, it is either outsiders like immigrants or minorities, or the government—not the wealthy.

As Manny has suggested, the situation is rather reminiscent of the USSR in its final years. In both cases we have an economic philosophy based on a priori logic rather than evidence, and believed on the same grounds. As this philosophy fails to deliver, the country’s elites still do not publicly renounce it, but instead only increase their displays of fervor. Rather, entirely irrelevant factors—immigrants, minorities, nefarious citizens—are used to explain the lack of prosperity. Meanwhile, the rich line their already deep pockets while spouting the old egalitarian slogans. The result is a society gripped by nihilism, wherein the old ideals become barely-disguised lies by corrupt and incompetent leaders, and anger and hopelessness descend upon a country that senses it is going in the wrong direction but does not understand why.

This may seem rather hyperbolic. But when you consider how bad things have gotten in the United States in the short time since the publication of this book, when it was already quite bad, then perhaps you can see the justification.

If our economic logic is often misguided, and our policies either useless or worse, what do the authors suggest? Here is where I thought that the book was mostly lacking. Banerjee and Duflo are extremely heterodox when criticizing conventional economics, but are not nearly so bold in proposing solutions. Their general point, however, is that we ought to shift our focus away from trying to grow the economy—since we do not know how to do that anyway—and towards most justly distributing the resources we have now. High tax rates on the rich will help curb inequality without reducing effective incentives. Coordinated efforts between countries can help to reduce tax dodging, and enforcing anti-trust legislation will help curb corporate power.

The authors have a fairly nuanced view of basic income. They think that basic income schemes work well in developing countries, where the poorest are mostly working a variety of temporary or seasonal jobs. But they do not think UBI would work in developed countries, because people have come to rely on jobs not only for income but for structure and even meaning in their lives. In studies, people who stop working do not tend to increase time socializing, or volunteering, or on hobbies; instead, most people end up just watching a lot of television—which does not increase happiness or well-being. This is why the authors prefer significantly stronger unemployment support—helping workers to retrain and relocate.

This seemed somewhat timid to me. But perhaps it is misguided to seek bold, sweeping solutions from authors who insist on hewing to trial, experiment, and evidence. Hard-headed economists, the authors do not promise miracles. Yet if you are looking for a probing and insightful look at many of our current economic woes—now only exacerbated by the coronavirus recession—then this book is quite an excellent place to start. The most pressing point is that our economical problems have political solutions. As usual, the only thing we need is the political will to start acting.

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Quotes & Commentary #69: Keynes

Quotes & Commentary #69: Keynes

It is astonishing what foolish things one can temporarily believe if one thinks too long alone, particularly in economics (along with the other moral sciences), where it is often impossible to bring one’s ideas to a conclusive test either formal or experimental.

—John Maynard Keynes

I have been thinking a lot about Keynes lately, and not only because I am reading a massive biography of his life. Keynes is one of those perennial thinkers whom we can never seem to escape. He exerted enormous influence during his lifetime and dominated economic thought and policy for thirty years after his death. Then, as inevitably happened, the Keynesian orthodoxy became too successful for its own good. His ideas came to be taken for granted, and his innovations became the conventional wisdom that the cleverest economists of the next generation came to reject. This ushered in the age of Neoliberalism—with Margeret Thatcher, Ronald Reagen, and Milton Friedman as the great standard-bearers—and the decline in Keynesian thought.

And yet, whenever there is a serious problem with the economy, everyone instinctively returns to Keynes. It was he who most convincingly analyzed the sources of economic recession and depression, and then plotted a way out of it. He was writing, after all, in the wake of the Great Depression.

To oversimplify the basic idea of Keynes’s analysis, it is this: High unemployment leads to a lack of demand, and a lack of demand can push financial systems beyond the breaking point. Put another way, the economy can be envisioned as an enormously complex machine that is composed of millions of cogs. Some cogs are small, some are large, and all are connected—either proximally or distantly. If one small cog stops working, then it may cause some local disturbances, but the whole machine can continue to chug along. But if too many cogs fail at the same time, the machine can come to a grinding halt.

As the coronavirus shuts down huge sections of the economy, this is exactly the scenario we are facing. Waiters, bartenders, actors, musicians, taxi drivers, factory workers—so many people face lay-offs and unemployment as businesses prepare to shut down. Besides this, if we are locked into our homes, then there are now far fewer places where people can spend their money, even if they have money to spend. It is inevitable that some people will not be able to afford rent, that some businesses will go under, and that much of the money that is available to circulate will remain unused in bank accounts. People are not going to be buying houses, or cars, or dogs, or much of anything in the coming weeks (besides toilet paper, of course).

Now, in a capitalist economy, anyone’s problem is also my problem, since buying and spending are so intimately related. The money you spend eventually becomes the money I receive, and vice versa. Thus, if there is a increase in unemployment (limiting the money you receive), an increase in bankruptcies (limiting the money the banks receive), and a decrease in spending (limiting the money I receive), then we have a recipe for serious economic contraction. A wave of bankruptcies inevitably puts pressure on banks; and if banks begin to collapse, then we are in grave trouble. Whether or not we like to admit it, banks provide an essential service in the economy, one which we all rely on. To return to my crude cog analogy, the banks are some of the biggest cogs of all; and if they stop turning, nothing else can move.

Keynes’s solution to this dilemma was essentially to use the government’s almost limitless ability to borrow money, and inject as much cash into the economy as possible. In other words, the idea is to stimulate demand, so that people can continue to spend money. It is an idea that has been criticized by so-called ‘responsible’ people for generations. Can the government really afford to go into so much debt during a recession? Can such artificial measures actually prop up an ailing economy? Can we tolerate such a huge degree of government involvement in a liberal society?

Republicans—and to a lesser extent, even Democrats—have been sharply critical of Keynesian economics over the years. When Obama wanted a stimulus package for the 2008 financial crisis, he faced endless opposition and criticism from the Republican party. And now that we are facing an economic crisis on a comparable scale, the Republicans are turning without hesitation to Keynes: hundreds of billions in stimulus, and even resorting to mailing checks to every American. One could hardly imagine a more straightforwardly Keynesian solution than this. Keynes had this to say about how the government could deal with a recession:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

This is the closest that Keynes got to the notion of simply giving people money. Paying people for absolutely useless work is better than nothing, since at least then people are being paid; and if they are being paid, they can spend their money; and if they spend their money, I can get paid; and so on. If this were a different kind of crisis—a kind where we did not have to practice social distancing—then perhaps we could imagine large-scale infrastructure projects as a way of combating recession. But now, we must resort to the even more radical idea of paying Americans to do nothing. Maybe Andrew Yang’s notion of a universal basic income is not so far after all?

Well, here is where I must warn my readers (all three of you) that I am really quite clueless when it comes to economics, so everything written here must be read in that spirit of ignorance. However, I think that Keynes’s quote is also quite relevant for non-economic reasons. As so often true in economics, we are facing an entirely novel situation. This is a crisis without precedent, and that means that all of our ideas of how to cope with the crisis are untested. The closest historical precedent to the coronavirus is the 1918 flu pandemic; and yet there are important differences between both the disease and the historical situation. We are thus operating without ‘conclusive tests,’ in Keynes’s words, of our ideas. It remains to be seen which country’s approach will be the wisest.

In the meantime, Keynes is an example for us to follow: an intellectual who responded to a historical crisis with both ingenuity and rigor. Let us hope there are many more like him.